Week 4: A Framework of the Islamic Financial System – Part 2 > Introduction > Unit
- After completing this chapter, you will be able to explain the concept of bai’ bithaman ajil, or bai’ muajjal, or credit sale, and the conditions for it, explain the concept of a murabahah sale, bai’ bithaman ajil facility, identify the conditions for a valid murabahah sale.
- You will be able to describe the structure of a murabaḥah contract, explain the murabahah to purchase order a contract, explain the steps in the MPO contract and the prerequisites for each step, and describe the various issues that need to be managed for murabahah contracts.
Week 4: A Framework of the Islamic Financial System – Part 2 > Concept and Conditions of a Bai’ Mu’ajjal (Credit Sale) > Unit
- Let us now discuss the concept and conditions of Bai Muajjal, or credit sale.
- The important forms of credit sales are Bai Bithaman Ajil, or Bai Muajjal, Murabahah, and Musawamah.
- Bai Bithaman Ajil or Bai Muajjal: Bai Bithaman Ajil, or Bai Muajjal is a credit sale where customers make deferred payment.
- Bai Bithaman Ajil implies that payment of price can be deferred regardless of whether the cost and markup are known to parties.
- In a Murabahah, which is a cost-plus sale, customers bargain on the profit margin over the known cost price.
- In Murabahah, the profit margin is fixed over the cost, and both the bank and the customer agree on the specified profit to be added to that cost.
- In the first step, the customer approaches the bank, he selects the commodities, and collects information of the base price and the markup.
- Now, what are the conditions for Bai Muajjal? All Islamic financial institutions should follow the conditions and rules outlined by the Shariah for sales directions.
- Mutual consent between the seller and the purchaser is mandatory for a sale contract.
- A cannot sell a car to B which he intends to first purchase from C. Since A does not own the car at the time of sale, the sale is void.
Week 4: A Framework of the Islamic Financial System – Part 2 > Concept and Conditions of a Bai’ Mu’ajjal (Credit Sale) > Unit
- The seller must physically or constructively possess the subject of sale at the time of sale.
- A has purchased an appliance from B. B has placed the appliance in a warehouse to which A has access.
- The risk of owning the appliance has practically passed to A. Therefore, A has constructive possession of the appliance and can sell it to a third party.
Week 4: A Framework of the Islamic Financial System – Part 2 > Murabaha Sale > Unit
- Islamic scholars like Imam Malik, Hanafi jurist al-Marghinani, and Hanbali jurist Ibn Qudamah essentially agree on the definition of Murabaha as a sale that involves a certain cost to the seller and his profit margin.
- The original cost and profit should be known to the seller and buyer.
- Such persons can deal with a Murabaha dealer and purchase goods by paying an agreed additional cost over the original price.
- Upon execution of Murabaha, the bank creates a receivable, and that becomes the liability of the customer.
- The aspect of disclosing the bank’s cost price details does not remain a serious issue between the bank and the customer because the customer is involved in locating and purchasing the goods.
- So what are the conditions of a Murabaha sale? Since Sharia permits Murabaha, all transactions under this type of sale should meet the general conditions that are applicable for an ordinary sale.
- The specific conditions regarding lawful transactions of Murabaha are related to the goods that are the subject matter of the Murabaha, the original price paid by the seller, any additional cost that serves as the basis of Murabaha, and the margin of profit charged on the cost.
- Condition two: Any currency and monetary units that are subject to the rules of Bai’al Sarf cannot be sold through Murabaha, as it requires simultaneous exchange of currencies.
- Additional expenses such as transport, processing, and custom charges can be added into the purchase price on the basis of Murabaha.
- If an Islamic bank receives a discount for goods purchased, even after the Murabaha sale, the buyer is eligible to benefit from the same discount.
Week 4: A Framework of the Islamic Financial System – Part 2 > Murabaha Structures > Uni
- As it is impossible for banks to train all its staff for this expertise, bank allows specific-purpose companies or third party agency to undertake trading and leasing activities.
- Bank make bulk purchases of high-value assets or specific goods with trademarks to build their inventory and sell them to clients on a cost-plus basis.
- Involving bankers in retail trade can lead to a lot of managerial problems and corruption.
- Banks appoint qualified suppliers as agent to purchase according to their inventory plans or as and when required by the client.
- The inventory creating plans agreement include a memorandum of understanding, sales deed executed at the time when the commodity is in the ownership of the bank, and a promissory note signed by the client.
- This structure of Murabaha, normally used by Islamic banks, is the safest way for banks to avoid commodity-based risk and related problems.
- If the banks makes direct payment for the good purchased and received by the client from the supplier, it will be a remittance of the amount of money on behalf of the client, which will be a loan to him.
Week 4: A Framework of the Islamic Financial System – Part 2 > Murabaha to Purchase Orderer > Unit
- he MPO comprises a master contract which define the overall facility to be availed, an agency contract whereby an agent should purchase an item and possess it on behalf of the bank, and an actual Murabaha contract which should be concluded when the bank owns the concerned commodity.The general structure of this variant involves six major stages such as pre-promise, understanding, promise stage, agency stage, acquiring position, execution of Murabaha, and post-execution.
- Across these stages, the relationship between the bank and the client is that of principal and agent, promisor and promisee, buyer and seller, seller and buyer, and creditor and debtor.
- In this stage, the bank and the clients sign a memorandum of understanding or what is known as agreement to sell.
- Prerequisites for the pre-promise stage are the contract between the bank and the client must be authentic.
- Murabaha cannot be used for providing liquidity or for business involving ready cash.
- The bank should check the credibility of the commodity from the point of view of risk, marketing value, uniqueness, and profitability.
- The client should be tested for cash flow and risk profile.
- Prerequisites for the promise stage are the bank signs the master Murabaha facility agreement, or MOU, that provides facility, commodity, payment, and security details.
Week 4: A Framework of the Islamic Financial System – Part 2 > Purchase Requisition > Unit
- It is mandatory according to AAOIFI standard that the client purchases the goods on behalf of the bank and the bank in turns pay the supplier.
- The purchase order, delivery report, and delivery channel should be in the name of the bank.
- Prerequisites for the agency stage are: an agency agreement can be signed along with the MOU but before the purchase of goods by the client, an agency agreement should be specific agency when the purchase of the commodity is not of a consistent nature, and general when the purchase of the commodity is of a consistent nature.
- In this stage, the client inform the bank about the purchase, the possession of the asset, and offers to purchase it from the bank at a profit margin.
- Prerequisites for purchasing stage are: any discount offer by the supplier should be passed onto the client while executing the murabaha sale by reducing the cost of sale, the bank or the principal must be informed about the price rise, the bank had the right to reject the purchase that does not tally with the agreed price.
- In compliance with the shari’ah, the bank takes ownership and possession of goods before executing the murabaha.
- A client may not take delivery of goods, use them before informing the bank and offer an acceptance.
- The bank appoint a person for physical inspection to ensure that the commodity exists in its original form.
- Prerequisite for the execution stage are: the customer takes possession of the good, gives a possession report and offer to purchase the good acquired by him on behalf of the bank, the bank accepts the offer and completes the transaction.
- The relationship of buyer and seller between the client and the bank transforms into a relationship of debtor and creditor.
- The bank can acquire any type of security based on the amount of facility, type of business, and reliability of the customer.
Week 4: A Framework of the Islamic Financial System – Part 2 > Issues in Murabaha Contracts > Unit
- The Shari’ah prescribes certain norms of free Murabaha from riba and other abuses to the system.
- Murabaha is an equity-based product that involves sharing of returns and risk.
- Possession under Murabaha may be physical or constructive, where the bank may not have taken the physical delivery of the commodity but is in control of it with all the rights that include even the risk of destruction and legal responsibilities.
- When a promise is made by a bank and its client, it is in the nature of moral obligation.
- If the price of a commodity varies between the first contract, which is between the bank and the vendor, and the second contract, which is between the bank and the client, either party will have an incentive to default.
- In Murabaha financing of education, the bank buys a right to enroll in the university and then resells it to a student at a markup price.
- A value sale require knowledge and specification of price and payment conditions.
- Both the price and the mode of payment are fixed at the time of contracting.
- The terms of deferred payment must be clearly specified, and once the price is fixed, it cannot be subject to modification.
- As a result, it is also natural and legal for an Islamic bank to standardize its Murabaha rates on par with lending rates of conventional banks.
Week 4: A Framework of the Islamic Financial System – Part 2 > Issues in Murabaha Contracts > Unit
- Interest rates are extremely unstable, and many conventional banking products have floating interest rate.
- The conversion of a fixed-rate facility into a floating-rate facility by opting for a debt rollover at a periodic interval is possible with a conventional bank but is not allowed by Murabaha.
- A rollover in Murabaha means that another Murabaha is booked on the same commodity, and this practice is prohibited by Shari’ah.
- Five, the bank may reschedule an installment, but this is not allowed in Bai’ bi Thaman al-‘Ajil Murabaha, as no additional amount can be charged as done by conventional banks.
- The Murabaha contract, apart from battling issues like sale contract, credit price, and legal inferences from combining promise and agency with the actual Murabaha contract, also faces allegation that it constitute two sale in one, the contract of a promise and the sale deed.
- It is a unilateral promise that remains a promise and does not take the form of a contract.
- Bai’al’Inah, generally known as buyback, is a double sale by which the borrower and the lender sell and resell an item among them, once for cash and then for a higher price on credit.
- Some banks specify in their contract that the defect is the responsibility of the buyer, and any discrepancy in the quantity or specification of goods is considered to be the liability of the seller.
- From a legal point of view, a buyer can avail Khiyar, a buyer can avail Khiyar al ‘Aib and Khiyar al Wasf if the goods are defective or are not according to the stipulated specifications and shall be compensated by good quality goods through the same or a new Murabaha.
- The bank can also specify that it shall not be responsible for any discrepancy once the goods have been inspected by the buyer and the Murabaha has been executed.
Week 4: A Framework of the Islamic Financial System – Part 2 > Issues in Murabaha Contracts > Unit
- A murabaha contract should be conducted only after the bank gets ownership on possession and is responsible for the loss or defect, this even recommended by the Shari’ah scholars.
- Agency contract, where a client buys a good on behalf of the bank and immediately sells it to the client are part of murabaha contracts.
- After the client takes possession of the good, there should be a separate offer receipt between the client and the bank.
- Some of the options to deal with late payments are: one, the client should pay to charity in case of default; two, Shari’ah scholars have authorized banks to impose late fees on delinquent clients, but the proceeds of such penalties can be used only for a charitable purpose.
- Only a court or an independent body can allocate any part of the penalty to the bank; and thirdly, course or any resolution committee appointed by the state can determine the compensation for the actual damage, but not for the loss of income calculated on the basis of conventional idea of opportunity cost.
- The organization of Islamic conference, fatwa of Fiqh academy, the Shariat Appellate Bench of the Supreme Court of Pakistan, Shari’ah committees of Islamic banks in the Middle East and Shari’ah scholars consider it to be similar to interest-based installment sales techniques.
- A rollover in murabaha means booking one murabaha against a receivable on a previous murabaha, and the payment for which has not been met by the client.
- There have been instances of Islamic bank conducting shares murabaha where they buy shares through our client as an agent and sell them on a murabaha basis to the client.
- Number three, banks can sell shares on murabaha basis once payment is made by the bank and the shares are transferred to it.
- Number four, in case settlement takes time, banks should wait for actual transfer.
- The risk of price fluctuation for three days has to be borne by the bank.
Week 4: A Framework of the Islamic Financial System – Part 2 > Commodity Murabaha & Risks and Mitigation Measures for Murabaha > Unit
- The banks use Tawarruq and appoint a commodity broker to purchase metal and subsequently sell it to a said broker or on a deferred payment basis on the same day.
- It doesn’t matter if any actual transaction takes place and when the risk is transferred to the bank.
- Risk and mitigation measures: In Murabaha, Islamic banks face additional risks like the asset risk, fiduciary risk, legal risk, and Shari’ah-compliance risk.
- One way to mitigate the risk is by paying special attention to completing documentation for the various contract under the guidance of the bank’s legal department.
- Let us now see some risk and mitigation measures for them.
- Risk one: Suppose the bank’s customer is acting as its agent to procure goods that the bank will sell back to customer.
- To protect against such a risk, at the time of appointing them as agents, bank can obtain a promise from the customer that they will buy the goods from the bank.
- The bank can use Hamish Jiddiyah and recover any losses from that.
- To protect its interests, the bank should make direct payment to supplier through a demand draft or pay order, obtain invoice for goods purchased and any other evidence, for example, gate pass, inward register, entry in a stock register, or truck receipt, inspect goods physically.
- Risk three: Suppose goods have been used by customer prior to offer and acceptance.
- Risk four: There is often a risk that goods owned by the bank will be destroyed in transit prior to offer and acceptance without agent’s negligence.
- To protect against such non-performance, bank can ask for guarantees from the agent.
- To prevent such fraud, banks must obtain and examine balance sheets, accounts, statements, and documents related to the company and its associates or subsidiaries before entering into any agreement.
